Target Date Funds Primer

March 5, 2012 — nicoleandmaggie

There’s a general consensus forming among the economics community (both academic and policy) that low-fee target-date index funds are the way that most people should be investing. In fact, they should be the default plan in most people’s 401(k) [default means what you end up with if you don’t pick something else]. Obviously people should be able to make their own investment decisions, but for the majority of people who are confused on these topics, a low-fee target-date index fund will best be able to get them where they want to go.

What is an index fund?

An index fund is like a broad based mutual fund that matches a market. Mutual funds are great because they allow smaller investors to diversify their portfolios. With an index fund, instead of paying a mutual fund manager hundreds of thousands or even millions of dollars each year to try to beat the market (which, incidentally, fewer than half of them actually do), a computer tracks the market of the index (often the S&P 500 or Russell 5000, but there are many others) and the index value is based on that. It is a low cost, lower risk, way of matching the market.

Bottom line is: index funds match whatever market they are indexed to at a smaller expense than a standard mutual fund.

Why low-fee?

Even with an index fund, your returns can be eaten away by fees. Some companies can use their index funds as money makers– they’re not paying money managers anything but they charge much higher fees than they should. This is especially likely when your choices for a 401(K) plan are limited.

If your choices are not limited, look very carefully at your options. If you have several options for index funds that track the same market, go with the company that charges the lowest fees. Vanguard is the lowest cost for index funds and for target-date index funds.

Ignore things like “returns since inception.” All index funds have the same returns for the same index– the only difference in “returns since inception” is whether they started (“inception”) when the market was booming (which shows low returns since inception) or the market was busting (which shows high returns since inception). It’s a meaningless metric.

What is a target date index fund?

A target date index fund is like a mixture of stock and bond index funds that tilts your exposure from stocks to bonds as you get closer to your chosen retirement (target) date. This is great because you don’t have to rebalance your portfolio. You don’t have to recalculate your risk every year. You can just set and forget and your portfolio will be taken care of.

The paradox of choice causes inaction. Figuring out what stocks to choose and what ratio of stocks and bonds can be overwhelming and can cause you to end up not doing anything at all. With a target-date index fund all you have to do is pick one number (and you don’t even have to really be correct!) and set up automatic contributions and the company will take care of the rest. They’ll automatically rebalance as markets change and they will shift your stock exposure into bonds as you need more sure money and less risk in your portfolio.

What date should you choose? Well, take a guess on what year you’re going to retire and pick the date closest to that. If you’re in your 20s now, it won’t matter that much if you get it off by 10 or even 20 years because you’ll still be tilted towards stocks and able to recalibrate for a while. If you’re closer to retirement, then presumably you have a better idea of when you’re going to need to start drawing down those funds.

Another note on fees

If Vanguard (whose target date funds reflect the actual cost of each index they use) is not one of your options, it may be worthwhile to compare the cost of a target-date index fund to matching it with regular index funds yourself. This is especially true if your target date is a long time from now– a target date fund will be heavily invested in stock indexes and you can set and forget for a while before you have to start shifting into bonds. Still, if this idea of having to choose your own portfolio intimidates you, it may be worth paying the additional fee for the Target date fund, even if it is more expensive.

For more information, Boston College has put out this handy primer. This pdf has a lot of great graphs and charts showing how target date funds perform under different scenarios, and this booklet provides more detailed information on the topic.

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12 Responses to “Target Date Funds Primer”

Very good explanation! I recall reading somewhere fairly credible (sorry, but the source escapes me) that when thinking about the balance formula for your retirement funds (as in stock vs. bonds, etc.) to take into consideration social security on that conservative side. I know so many people say not to count an any social security at all, but if one does believe that there will be some social security income when one retires, that argument does make sense. In practical terms, since I’m nearly 45, the rule of thumb is that I should have only about 40% of my retirement investments in something high risk like stocks. However, if one factors social security into in the low risk side, I could conceivably have a higher amount than 40% invested in stocks. Maybe I haven’t got that quite right, but I’d be interested in hearing others thoughts on this.

In relation to target funds, I wonder if social security is taken into consideration?

I’ve heard good things about target funds, too, but I don’t use them because I like to know more about what I’m investing in. So far Vanguard doesn’t have a “socially conscious target fund.” At least not that I’ve found.

You should look at the actual allocations and plans for allocations for the target date funds, not the date. So, however you want to account for things like SS or maybe a pension, you should pick the target date which matches your equity/bond allocation desires, not when you think you would need to retire. This is one of the issues with the Target Date funds for those who like to have biases or tilts in their portfolio. Another option is to have a portion in a Target Date and make your biases with the rest of your portfolio.

One interesting thing about half of the actively managed funds beating their index is that probably very few continually do it year over year. And even fewer do it for long term horizons. And if you believe in return to mean theory, you would need to know when to get out. Most people in Fiedlity’s Magellan fund didn’t know when to get out, so they are back to where they would have been with an index, but they paid the higher fees.

Social security is interesting– when you make more, it replaces less of our income and becomes less important to our overall portfolio. Additionally, benefits will be cut in the future but we do not know how much and when. Taxes will go up as well, but again, how much and when is a mystery.

Different target date funds have different investment allocations in terms of their stock/bond mix for each target date. My feeling is generally that I can’t do any better at predicting the future than they can, so who knows which is the “right” or “best” allocation. Not me!

I started to comment earlier and then thought “eh, what I’m saying is interesting only to me,” so stopped, but now see that what I was writing about is sort of related to Linda’s comment and the replies. So.

A great post and very helpful in making key points like, it is better to do something (save) than not, and one can achieve a few key goals (keep expenses low, diversify) pretty simply. All good. But virtually all discussion of saving-for-retirement drives me mildly batty in that it it (over)simplifies our lives to make us no more than an individual with an income and an age — maybe, if we’re lucky, a gender. My life feels far too connected to others’ for that to work (the older and younger generations to which I’m connected as a child or parent including in-laws and steps makes 5 households plus my own). As a grossly simple example I count myself fully diversified knowing that to purchase an annuity equivalent to the 100% survivorship I hold in my husband’s pension would cost about twice as much as the value of my retirement accounts which are — for that reason — virtually fully invested in stocks.

On the other hand, the AARP magazine recently assured me that, no, really, it’s easy to know how much I need to save for retirement! I only need to know 3 things — (1) how much money I will need in retirement per annum; (2) the rate of return on my investments; and (3) how long I’ll live. Phew. Here I’ve been thinking this was so complicated. Now where is that darned crystal ball?

Your “ask the grumpies” is scheduled for Friday. It’s probably not much more informative than the AARP article though! (And it basically comes to the conclusion: who knows, but here’s a heuristic or two.)

I remember my father telling my sibling to start saving for retirement. So I think default plans are a good idea for people who are not a sibling of mine. How else are they supposed to know? (Not that my dad told me to start saving…but I guess we’d talked about stocks before.) And seriously, have you seen the number of choices? I have a hard time just picking what to order for lunch. Retirement savings and the many ways one can save for the future is enough to cause full-on analysis paralysis except by choosing low-cost index funds.

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